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Summary of Prudential response to debt under Covid-19: the supervisory challenges

Core Content

This FSI Brief discusses the prudential implications of debt relief measures introduced in response to the Covid-19 pandemic, focusing on public guarantees and payment deferrals. It highlights the supervisory challenges faced by prudential authorities in assessing credit risk and regulatory capital under these measures, and outlines the regulatory guidance provided by the Basel Committee on Banking Supervision (BCBS) and national authorities.

Main Points

1. Debt Relief Measures and Their Purpose

• Governments and banks introduced public guarantees and payment deferral programmes to support struggling borrowers.
• Public guarantees shift risk to the public sector, preserving lending incentives.
• Payment deferrals provide temporary relief to cash-strapped borrowers, but deferred payments must be repaid later, increasing future risk.
• These measures apply to different segments of banks' credit portfolios, and vary in eligibility criteria, duration, and scope.

2. Prudential Treatment of Debt Relief Measures

• The BCBS and national prudential authorities have issued guidance on how to treat debt relief in prudential frameworks.
• Non-performing exposures (NPEs) are defined as past due by more than 90 days or unlikely to pay (UTP).
• Forbearance refers to concessions made to borrowers in financial distress, and may lead to NPE classification if it constitutes a distressed restructuring.
• During the pandemic, payment deferrals are not automatically classified as past due for regulatory purposes, but UTP assessments remain crucial.

3. Impact on Regulatory Capital Calculation

• Credit risk is a major driver of regulatory capital requirements, particularly the Common Equity Tier 1 (CET1) ratio.
• The CET1 ratio is calculated as:
  $$
  \text{CET1 ratio} = \frac{\text{CET1 capital (common shares + retained earnings + other reserves)}}{\text{Risk-weighted assets (RWAs) (credit + market + operational RWAs)}}
  $$
• ECL provisions (Expected Credit Loss) affect both the numerator (CET1 capital) and denominator (RWAs) of the CET1 ratio.
• Regulatory relief measures aim to reduce the cliff effect of ECL on capital ratios by allowing add-backs of provisions for 2020 and 2021, which are then phased out over the next three years.
• For sovereign-guaranteed loans, the sovereign risk weight may replace the obligor risk weight in the denominator, reducing capital requirements.

4. Supervisory Challenges

• Temporary relief measures may distort prudential metrics such as the stock of NPEs and the CET1 RBC ratio.
• Delayed loss recognition can lead to an understatement of credit risk, potentially masking underlying financial weaknesses.
• The exit strategy from these measures is a key challenge: acting too early risks limiting credit availability, while acting too late could undermine regulatory confidence and increase systemic risk.
• Supervisors must balance supporting economic recovery with maintaining financial stability.

Key Supervisory Actions

• Ensure UTP criteria are applied independently of public guarantees to accurately identify problem assets.
• Assess whether Pillar 1 capital requirements are sufficient for banks with high NPE and low-quality asset exposure.
• Determine the realizability of "interest accrued but not collected" for deferred loans, as these amounts may need to be reversed if repayment fails.
• Provide clarity on partial guarantees to enhance confidence in the prudential regime.
• Encourage alternative credit modifications, such as principal haircuts, for borrowers unlikely to repay, to better reflect credit risk.

Conclusion

The temporary regulatory relief measures introduced by the BCBS and national authorities aim to support credit flows and mitigate economic fallout from the pandemic. However, these measures raise significant supervisory challenges, particularly in accurately reflecting credit risk and capital adequacy in prudential assessments. The timing and phasing out of these measures will be critical in maintaining financial stability and regulatory trust. The exit strategy must be carefully managed to avoid both over-support and under-support of the banking system, with the right balance between economic recovery and financial resilience.

Key Takeaways

• Debt relief measures (public guarantees and payment deferrals) are essential to support the economy during the pandemic.
• Regulatory frameworks have been adapted to accommodate these measures, but supervisory challenges remain.
• Accurate assessment of credit risk and capital adequacy is vital to ensure financial stability.
• The exit from relief measures is a delicate process requiring judgment and timing to avoid adverse outcomes.

References

• BCBS (2017a, 2017b, 2019, 2020)
• Baudino (2020)
• Coelho and Zamil (2020)
• FSI Briefs (no 3, 5, 8)
• OSFI (2020a, 2020b)
• PRA (UK), FDIC (US), EBA (EU), Reserve Bank of India, Central Bank of Brazil, and others.